Over recent years, warranty and indemnity (W&I) insurance has been slowly gaining popularity. Now, it is grabbing the attention of advisors, investors and promoters at the negotiation table in almost every merger and acquisition (M&A) transaction. Over the last decade, Indian M&As have witnessed a tremendous boom across sectors, with foreign investors betting heavily on the India story. It is not long before W&I insurance becomes standard practice for most M&A transactions.
Although the basic principles and processes for every M&A transaction in India have been adopted from developed markets, the Indian M&A story is still evolving. In India, as well as abroad, the bedrock of every M&A transaction continues to be the reliance of the buyer on various representations, warranties and indemnities of the seller. Over the years, various structures from holdback to escrow have evolved to provide the buyer much-needed relief in case of any of the representations of the seller being untrue. However, enforcement of these provisions and risk of long-drawn litigation in India continue to be the worst nightmare of every foreign investor. With all these challenges, it is difficult to ignore the prospects offered by W&I insurance.
Types of W&I insurance
W&I insurance is a commercial insurance policy that covers financial losses incurred by a party due to the breach of warranties provided by the share purchase agreement or similar pact. W&I insurance policy is of two types: buy-side and sell-side.
The buy-side policy would typically cover losses incurred by the buyer due to breach of representations and warranties provided by the seller in the transaction documents. Certain unknown issues may not have been known to the buyer at the time of due diligence or negotiations with the seller. Issues that are known to the buyer are not generally covered by W&I insurance.
The sell-side policy would typically cover costs incurred by the seller in defending a claim initiated by the buyer.
W&I insurance is typically provided by insurers for a period of three years in case of business/operational representations, and for five to seven years for tax and fundamental representations.
Like any insurance policy, W&I insurance comes with exclusions and riders. The insurer will request a policy retention amount, which can be equal to the de-minimis threshold and the basket threshold agreed upon by the seller and the buyer in the transaction documents. This is a matter of negotiation and depends on several factors (for example, scope of guarantee and magnitude of risk). The typical exclusions include any known issues specific to the transaction, transfer-pricing issues, known tax claims/demands and any forward-looking statements (like target company attaining estimated results). In case of a sell-side policy, fraud committed by the seller is also typically an exclusion from W&I insurance.
If a buy-side policy is being obtained, the purchaser should be wary of negotiating the “knowledge” qualifier provided by the seller to the buyer in the transaction documents. In most cases, the buyer will also not be able to bring in claims for any warranties with knowledge qualifiers that have been provided by the seller unless these are specifically discussed with the insurer. In some instances, the insurers may cover known issues, subject to detailed evaluation, for a higher premium. Insurers prefer highly negotiated documents.
Advantages of W&I insurance
In the global M&A scenario, nearly 80% of all policies are buy-side and the rest 20% are sell-side. W&I insurance provides certain advantages both to the buyer as well as the seller.
For the buyer, W&I insurance, among other things, helps in the following ways: a higher amount in case of breach by the seller as well as an increase in the period of protection; faster recovery of damages in case of breach; in a bid scenario, the buyer seeking W&I insurance is likely to hold an advantage over other buyers relying on holdback, escrow or similar structures; W&I insurance helps expedite negotiation process with the sellers or promoters; and helps provide greater comfort to buyer than other structures.
For the seller, W&I insurance, among other things, provides the following advantages: clean exit without the sale consideration being blocked via holdback or escrow; expedition of the negotiation process; comfort to the counter-party since the deal is being offered with a comprehensive insurance policy; availability of finance in case of defending claims from buyer; and if seller is a private equity player, distribution of sale proceeds to investors without having to hold back any funds.
Obtaining insurance, and its costs
Before issuing W&I insurance, the insurer will thoroughly evaluate the business of the target company and evaluate the nature of representations, warranties and indemnities provided or proposed to be provided by the seller or the management. Based on the evaluation, the insurer’s lawyer will draw up a report and policy terms, including exclusions, which would be submitted to the party intending to procure insurance. W&I insurance can be obtained either by the buyer or the seller or by both. The premium for obtaining such a policy is one-time and usually ranges between 2.5% and 4% of the policy value, depending on the nature of the policy obtained by the parties.
W&I insurance in India
W&I insurance is widely accepted in developed economies; however, it is still early days in India. Very few insurance companies are currently offering W&I insurance as a product due to overall lack of awareness. Being a fairly sophisticated product, expertise seems lacking in the Indian insurance market. Due to this, most of the W&I insurance policies in the Indian market (especially the larger ones) are made overseas in markets like the United Kingdom and Singapore.
Further, due to lack of demand and very few insurers currently offering this product, the overall premiums are high in India, making W&I insurance an unviable option in certain transactions, especially where the deal valuation is low. The Indian M&A space, at a nascent stage, is also yet to witness large payouts under W&I insurance policies, leaving the market with few or almost negligible precedents for reference.
However, the Indian market is opening up to this new offering and increasingly parties are looking at W&I insurance as an alternative to the expensive dispute resolution process. Parties are seeing W&I insurance as a means to expedite the long-drawn negotiation processes under the M&A cycle. As the market matures and demand rises, the premiums are expected to come down significantly, making W&I insurance more affordable and viable for transactions. The pros that W&I insurance can offer far outweigh the cons. It is just a matter of time before advisors and parties start insisting on W&I insurance as a pre-requisite for negotiating M&A transactions.
Jayesh Kothari is a senior associate at DSK Legal.
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